Social protection and taxation feature prominently as key policy instruments available to governments in the pursuit of development goals in both the Financing for Development (FFD) Addis Ababa Action Agenda and the Sustainable Development Goals (SDGs). This renewed interest in social protection and tax presents a precious opportunity to promote the closer consideration of the links between the two and the ways in which they operate jointly to shape development outcomes.

Francesca Bastagli is Head of Social Protection at the Overseas Development Institute (ODI) and Senior Visiting Fellow at the Centre for Analysis of Social Exclusion (CASE) at the London School of Economics (LSE).

The case for closer joint consideration of taxes and transfers

Social protection and taxation have emerged as two of the key policy instruments available to governments in the pursuit of the development goals in the FFD and SDG processes. This reflects a growing recognition among policy makers in the international development context of the powerful role fiscal policy plays in shaping development outcomes. It also represents an important opportunity for the closer consideration of the ways in which taxation and social protection operate jointly in practice.

Taxes and transfers commonly continue to be discussed separately, yet in practice they interact to shape the distribution and redistribution of income and wealth both directly – through the distribution of transfers and the tax burden – and by influencing processes of government accountability and legitimacy, the quality of service provision and people’s willingness to pay taxes.

On the social protection side, its expansion in developing countries over the last two decades has been supported by a growing evidence base highlighting its impact on poverty and inequality. Studies of the distributional effect of transfers provide essential information on policy performance and on the policy features that facilitate progress towards development outcomes. However, when such analyses consider social protection separately from tax policy, they produce at best a partial picture of the impact of fiscal policy. Evidence that in some countries the net effects of government spending and taxes leave the poor worse off underscores the importance of adopting a comprehensive approach which encompasses both taxes and spending.

On the tax side, the recent discussions have emphasized its revenue generating potential. In the Addis Ababa Action Agenda, the outcome document from the Third International Conference on Financing for Development, taxation is presented as one of the main policy options available to government to raise the ‘significant additional domestic public resources’ that will be critical to achieving the SDGs. Commitments are mainly phrased in terms of providing support to improve domestic capacity for tax and revenue collection and administration. The FFD Action Agenda goes so far as to ‘welcome efforts by countries to set nationally defined domestic targets and timelines for enhancing domestic revenue’.

Less attention has been paid to the redistributive role and distributional implications of taxation. The FFD Action Agenda refers to ‘progressive tax systems’ and to their ‘fairness’ mainly as being functional to enhancing revenue collection. In the Open Working Group (OWG)’s Proposal for the SDGs, ‘fiscal policies’ are mentioned as a broad set of tools for achieving progress towards Goal 10 on reducing inequality. While these references are to be welcomed, they suggest that a higher priority continues to be accorded to increasing revenue rather than to the potential for taxation to shape distributional and broader development outcomes.

A recent ODI paper reviews the evidence and highlights both the distributional implications of taxes and transfers and why a fair and effective tax system matters to social protection financing and its sustainability.1

Taxes and transfers can be powerful redistributive instruments

If appropriately designed and implemented, taxes and transfers can make a significant dent in poverty and inequality. As the recent ODI paper shows, in high-income OECD countries, direct taxes and transfers alone contribute to an average 30 per cent reduction in income inequality, reducing the average Gini coefficient from 0.41 to 0.29. In comparison, in developing countries, their impact is more muted. In Latin America and the Caribbean, for instance, direct taxes and transfers contribute to a 4 per cent reduction in income inequality, from an average Gini coefficient of 0.51 to 0.49.

Variations in the distributional impact of fiscal policy reflect variations in government revenue and social spending levels. Their composition also matters, as do the design and implementation details of policy that shape the size and incidence of taxes and transfers and the ways in which they interact in practice. As a result, there is limited scope for generalizations on the impact of particular categories of taxes and transfers. Still, some patterns emerge, and point to the areas in which policy makers need to focus efforts to ensure that the policy priority of making progress towards the SDGs is reflected in policy design and implementation details.

On the tax side, given the dominance of indirect taxes in the tax structure of developing countries, the distributional consequences of such taxes are of particular importance. Evidence that consumption taxes are regressive in some countries (seven out of 12 developing countries studied here) and risk offsetting progress towards poverty and inequality reduction, points to the scope for policy adjustments that address equity concerns. Evidence of the distinctive ‘revenue gaps’ arising from the high—and in some countries growing—reliance on tax exemptions, the under-taxation of land and property and of the wealth and incomes of wealthy individuals, and associated tax avoidance and evasion practices, points to the scope for policy reforms which pursue both revenue generation and redistributive objectives. On the social protection side, low transfer values reaching low-income groups and low coverage limit the distributional impact of policy.

Why taxation matters to social protection financing

Compared with social protection financing alternatives, such as expenditure reallocation and reliance on additional external financing, taxation displays some key distinguishing features and potential advantages. These include taxation’s potential role in establishing and strengthening government legitimacy and state-citizen relations. By promoting government accountability, effective tax systems can be associated with a ‘virtuous cycle’, whereby tax collection is linked to improved service provision and increased citizens’ willingness to pay taxes.

The fairness of the tax system is critical in this respect. The unfair distribution of the tax burden, if associated with unequal distribution of income and wealth, can result in low levels of trust in institutions, low tax morale and high tax avoidance and evasion. Another critical factor concerns tax diversification. Especially in countries where tax collection derives predominantly from the business of extracting natural resources, state leaders may be less accountable to their citizens because such revenues are ‘unearned’. High reliance on revenue from natural resources is also associated with volatility, instability and sustainability concerns.

The comparatively low average tax to GDP ratio in many developing countries explains, at least in part, the persistent high reliance on external financing for social protection spending. Moreover, where increases in tax revenue have been recorded, they have been linked to the expansion of consumption taxes and revenue from natural resources. External financing and revenue from natural resources and consumption taxes have proved critical to supporting the introduction and expansion of social protection. However, they also raise sustainability and equity concerns. These can be addressed through initiatives aimed at building countries’ institutional and administrative capacity for social protection, ensuring the transparent management of resources and designing tax and transfer policies that take equity and broader development concerns into account alongside other policy objectives, such as raising revenue.

Bringing the fairness and distributional implications of taxation to the SDGs

Both the FFD Action Agenda and the SDGs contain strong language on the need to provide social protection systems and measures for all. In July 2015, world leaders in Addis Ababa agreed on a commitment to delivering social protection and essential public services for all through a new social compact to ‘end poverty in all its forms everywhere’. The SDGs include a target on implementing ‘social protection systems and measures for all’.

This commitment will require resources both from domestic tax collection efforts and from international public finance.2 As they currently stand, the commitments on domestic tax collection are mainly phrased in terms of generating revenue. In addition to generating resources for the financing of social protection and the broader social compact, tax policy and tax administration decisions will have direct poverty and inequality implications. They will also influence whether and to what extent tax systems contribute to the establishment and strengthening of government accountability, state-citizen relations and the sustainable financing of social protection policy.

As the implementation of the 2030 Agenda for Sustainable Development is debated in the months to come, efforts to support the financing of social protection for all will benefit from the careful consideration of the ways in which taxes interact with social protection policies to shape development outcomes in practice.

FOOTNOTES1 The paper is an output of a DFID-funded project on ‘Bringing taxation into social protection analysis and planning’.

2 Recent studies of the costs of financing the social compact show that the resources of the world’s poorest countries would fall short of the resources required, even if countries managed to raise taxes up to their economies’ capacities and including existing aid flows. See here, for example.

ABOUT THE AUTHOR

Francesca Bastagli is Head of Social Protection at ODI and Senior Visiting Fellow at the Centre for Analysis of Social Exclusion (CASE) at the London School of Economics (LSE). She specialises in social policy, with a focus on the design, monitoring and evaluation of social protection policies and their poverty, inequality and employment outcomes. She holds a PhD in Social Policy from the LSE and a Laurea in Economics from Bocconi University.